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Make the most of company stock

More than 15 million people own about $400 billion of company stock in Fidelity-administered workplace retirement plans alone. If you own company stock in such a plan, a little-known tax break could save you a bundle on taxes—if you qualify.

One day, anyone who owns company stock will have to decide how to distribute those assets—typically when you retire or change employers. Taking a distribution could leave you facing a tax bill, but a little-known tax break—dealing with net unrealized appreciation (NUA)—has the potential to help.

“The tax treatment of net unrealized assets could be a significant break for an investor with a sizable company stock holding, particularly if the assets have grown a great deal or they plan to tap the funds in the short term,” says Steve Feinschreiber, senior vice president of research in Fidelity Strategic Advisers. “Of course, you don’t want to let taxes dictate investing decisions. Make sure to first consider the sale in light of your asset allocation, and long-term plan—then see if this tax strategy makes sense for you.”

Defining NUA

Net unrealized appreciation is the difference between the price you initially paid for a stock (its cost basis) and its current market value. Say you can buy company stock in your plan for $20 per share, and you use $2,000 to purchase 100 shares. Five years later, the shares are worth $35 each, for a total value of $3,500: $2,000 of that figure would be your cost basis, and $1,500 would be net unrealized appreciation.

Why should you care about net unrealized appreciation? When you want to distribute company stock or its cash value out of your 401(k), you will face a choice: Roll it into an IRA, or distribute the company stock into a taxable account and roll the remaining assets into an IRA. The latter option might be more effective, depending on your circumstances, thanks to IRS rules governing net unrealized appreciation of company stock.

When you transfer most types of assets from a 401(k) plan to a taxable account, you pay income tax on their market value. But with company stock, you pay income tax only on the stock’s cost basis—not on the amount it gained since you bought it. (If you are under age 59½, you may also pay a 10% early withdrawal penalty.)

How to qualify for NUA treatment

You must meet all four of the following criteria to take advantage of the NUA rules:

You must distribute your entire vested balance in your plan within one tax year (though you don’t have to take all distributions at the same time).

You must distribute all assets from all qualified plans you hold with the employer, even if only one holds company stock.

You must take the distribution of company stock as actual shares. You may not convert them to cash before the distribution.

You must have experienced one of the following:

Separation from service from the company whose plan holds the stock (except in the case of self-employed workers)

Reaching age 59½

Total disability (for self-employed workers only)

Death

“The IRS enforces these rules strictly,” says Feinschreiber. “If you do not meet one of the criteria—for example, if you fail to distribute all assets within one tax year—your NUA election will be disqualified, and you would owe ordinary income taxes and any penalty on the entire amount of the company stock distribution.”

For more information on these complex rules, as well as situations that trigger additional tax restrictions, review IRS publication 575, Pension and Annuity Income, which is available at IRS.gov.

When to choose NUA treatment

Consider the following factors as you decide whether to roll all your assets into an IRA or to transfer company stock separately into a taxable account:

Tax rates. The larger the difference between the ordinary income tax rate and the long-term capital gains tax rate, the greater the potential tax savings of electing NUA tax treatment of company stock.

Absolute NUA. The larger the dollar value of the stock’s appreciation, the more the NUA rules can save you on taxes.

Percentage of NUA. A NUA that is a higher percentage of total market value creates greater potential tax savings, because more of the proceeds will be taxed at the lower capital gains rate and less will be taxed at income tax rates.

Time horizon to distribution.The longer you plan to keep your assets invested in an IRA, the greater the potential benefit of that account’s tax-deferred growth. A shorter time frame makes the NUA election more attractive.

A case study

An executive in the 39.6% tax bracket decides to retire at age 50. She holds $100,000 worth of company stock with a cost basis of $20,000, resulting in net unrealized appreciation of $80,000, and she wants immediate access to the cash.

She decides to distribute the assets into a taxable account and elect NUA tax treatment. She pays income tax and a 10% early withdrawal penalty on just her $20,000 cost basis—a total of $9,920. She then immediately sells her company stock and pays 23.8% capital gains tax on the stock’s $80,000 NUA. In all, she pays taxes and penalties of $28,960, leaving her with $71,040.

Considering the net unrealized appreciation rule

Assumptions: (1) Company stock with a $100,000 market value, a $20,000 pretax basis, and appreciation of $80,000 is distributed in-kind from a 401(k) plan as part of a lump-sum distribution; (2) in the Elect NUA scenario, the stock is immediately sold after being distributed from the plan; (3) in the Rollover IRA scenario, the stock rolled over to the IRA is immediately sold and the proceeds distributed in cash; (4) 39.6% federal ordinary income tax rate on the $20,000 basis in the NUA scenario and on the entire $100,000 in the IRA scenario; (5) 20% federal long-term capital gain tax rate plus a 3.8% medicare surcharge on the NUA in NUA scenario; and (6) participant is subject to an early withdrawal penalty of 10% on the $20,000 basis in the NUA scenario and on the entire $100,000 in the IRA scenario. State and local taxes are not taken into account. All the other non-stock assets distributed from the plan are assumed to be rolled over to a tax-deferred account to maintain their tax-deferred status and are not considered for purposes of this example.

Imagine she instead rolled her company stock into an IRA, then sold the shares and withdrew the cash. In that case, she would pay income tax and penalties on the entire $100,000, for a total of $39,600 in income tax and $10,000 in early-withdrawal penalties. As a result, she would wind up with just $50,400.

Please note results will differ depending on an individual’s holding period and percentage of NUA, but in this scenario, NUA tax treatment is clearly the better choice: The executive’s high tax bracket and substantial NUA, both in absolute terms and as a percentage of her company stock’s market value, enabled the NUA rule to produce considerable tax savings. If, on the other hand, the executive planned to wait for 15 years or more to tap her company stock, the full IRA rollover likely would have been more advantageous. Whether she left the company stock in the IRA or sold it to invest in other securities, her investments could have generated tax-deferred growth—which eventually would probably outweigh the NUA’s initial tax savings.

The importance of advice

The decision whether to take NUA treatment can be complicated. Certain situations may trigger restrictions on the NUA strategy. What’s more, you should consider the way your distribution strategy affects your overall financial plan, including your estate plan, charitable giving, and—perhaps most important—the level of diversification in your portfolio. A tax professional and financial advisor can help you determine whether the NUA rule applies to your individual circumstances and, if so, how best to deploy it.

Next steps

Before investing, consider the fund's investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus containing this information. Read it carefully.

The tax and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.

Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "